Europe Goes to Market: Opportunities and Challenges with a Trail Blazing Trading System
By Joe Kruger and Billy Pizer
Europe is about to launch an ambitious effort to curb its carbon dioxide emissions, regardless of whether the Kyoto treaty on climate change ever goes into effect. To hold down regulatory costs and reduce the impact on their economies, the Europeans will rely on detailed rules encouraging companies to trade emissions permits with each other. How well this approach succeeds could dictate the way future greenhouse gas reduction mandates are crafted.
This program is modeled on existing American systems for trading emissions permits for sulfur dioxide and nitrogen oxides. But the European plan is much larger and more intricate than its American counterparts, and it is being put into effect much faster.
The degree to which it succeeds or fails is likely to influence deeply any future international attempt to reduce greenhouse gas emissions and the climate change that they cause. The more effectively the trading program cuts the costs of compliance, the more likely it becomes that the emissions control regime will eventually include other countries.
Although the United States has rejected a mandatory emissions trading approach, there have reportedly been discussions between European and U.S. state government officials about linking the European program to a regional greenhouse gas initiative under development by states in the Northeastern United States.
Greenhouse Gas Trading in Europe: The New Grand Experiment
The American programs for trading sulfur dioxide and nitrogen oxide emissions have resulted in dramatic savings below the originally estimated costs of reducing emissions. But the European carbon-trading scheme differs in several respects that will make it significantly harder to manage.
In the United States, controls on the release of sulfur dioxide are limited to the electric utilities and cover about 3,000 boilers. The European plan covers more than 12,000 sources—not only electric power generators but also oil refineries, steel mills, cement plants, and a wide range of other industrial installations.
The American program’s annual allocation value—the price of a ton of gas times the number of tons allocated—is about $2.5 billion. The annual allocation value of the European program will be at least 10 times that amount and, depending on the market price of a ton of carbon dioxide, perhaps much more.
The U.S. Environmental Protection Agency took four years to develop its sulfur-trading program. The European Union’s rules are much more accelerated—with the final directive appearing in the fall of 2003 and going into effect at the beginning of 2005. Meanwhile the EU, as an institution, is devoting most of its attention to its expansion, bringing in 10 new members from Eastern Europe and the Mediterranean.
More troublesome are the issues of reporting, monitoring, and verification of emissions. Monitoring is left largely to the European Union’s 25 member states, under guidelines considerably more flexible than in the American programs. One reason for the flexibility is that the European permit market will encompass a much wider range of industries than its American counterpart. But another is that the Europeans have chosen, consistent with past European environmental policy, to keep the administration decentralized.
Emissions are to be verified independently, either by agencies within the EU member states or by third parties, firms that specialize in that work and that are certified by the member states. Use of these third party verifiers could provide an important source of expertise for those member states with limited internal capability to verify emissions. But because there are no uniform, mandatory standards for certification of qualified verifiers, there is the prospect that different verifiers will have inconsistent capabilities. Many technical and process questions lie ahead for a system that uses third party verifiers. When interpretations differ, who will resolve them? Will there be a case law of decisions that all verifiers must follow? If not, companies will be tempted to shop for the verifiers who provide the most lenient treatment of emissions accounting. That could quickly lead to a race to the bottom of the enforcement scale.
A permit trading system demands accurate accounting, providing a precise and open electronic registry of who owns what permits. The EU program adds a layer of complexity by allowing each member state to maintain its own registry. Nations may join together to share registries, but because of sovereignty and political reasons they may not choose to do so.
There is also to be a computerized central transaction log run by the European Commission. Although this decentralized registry system is technically feasible, it is considerably more complicated than running a single and uniform registry. In the United States, even the multi-jurisdictional nitrogen oxides trading program, which includes 21 states and the District of Columbia, has one centralized registry run by the EPA to track allowances.
Among the 25 different EU member states, there are dramatically different legal systems, enforcement cultures, and administrative capabilities. Uneven enforcement from one country to another would create unfair competitive advantages for companies where the enforcement regime is weaker. This possibility has already begun to generate concern in Europe. In most of the 10 countries joining the EU this year, environmental institutions have been weak historically.
While the European Trading System is now binding law and the member states are required to carry it out, the European Union has a tradition of relying chiefly on nudging and cajoling rather than punitive action to enforce compliance. Commentators have written of the “implementation gap” in European environmental regulation. A recent EU survey admitted that “there is difficulty in the timely and correct implementation as well as proper application of community environmental law by Member States.”
In addition to significant implementation challenges, there is considerable uncertainty about the costs of compliance with the European emissions trading system. Costs will be affected by how fast emissions will grow in Europe, by whether Russian will ratify Kyoto and therefore provide a source of low cost emissions reductions, by whether there will be adequate supplies of low cost emissions reductions from developing countries, and by a number of other factors. Moreover, rules that allow constraints on the ability to “bank” early reductions of emissions for later years could complicate planning for industry and reduce liquidity in the emissions trading market.
And yet, despite all the doubts and concerns that it raises, the European Trading System could be an essential element of efforts to reduce the world’s emissions of greenhouse gases and to reduce the impact of human activity on the global climate. It could also provide a wealth of data and experience on the cost of emissions reduction in an advanced industrial society.
Perhaps it won’t greatly affect the development of the Kyoto structure, since the Kyoto Treaty runs only to 2012. But the European experience with trading will undoubtedly influence what comes next in the world’s struggle to get control of the gases that are changing the climate. The United States has demonstrated that, in one country, emissions trading is not only possible but effective. The Europeans are now going to explore the possibilities when trading crosses national boundaries.
Joe Kruger is a Visiting Scholar and Billy Pizer is a Fellow at Resources for the Future, a Washington, D.C.-based energy and environment think tank.